How the Great Recession Impacted Estate Planning

[IMGCAP(1)]The great recession of 2007-2010 wiped out almost 40 percent, or two decades worth, of Americans’ wealth, the Federal Reserve said earlier this year. This shift in wealth will have a major impact across all aspects of family and wealth, not only for the middle class but also for wealthier people and business owners.

The brunt of the blow fell on the backs of the middle class because their major financial asset and wealth builder—real estate in their homes—was so negatively impacted. According to the Fed study, the median value of Americans’ stake in their homes fell by 42 percent between 2007 and 2010, to $55,000, or where they were in 1992. Losing a job for an extended amount of time also set the middle class back, severely impacting their retirement savings plans and restricting their access to credit in the future because of missed payments.

Owners of businesses and other wealthier people were less affected. Their median net-worth actually rose a little. They had assets that could bounce back with the markets, such as stocks and bonds. Their businesses could regain value once the economy picked up again and profits were better.

In addition, the wealthy had advisors who put them into instruments that shielded them better from the whipsawing capital markets. However, they weren’t immune from the recession either. A nonprofit pro-financial regulation group called Better Markets estimated that the financial crisis cost $7.6 trillion in actual and projected economic damage from 2008 to 2018. Let’s review the ways in which the recession has and will impact family planning and transfer of assets.

You Can Still Protect What Assets You HaveCurrent estate planning rules are advantageous to protecting assets and transferring wealth with less tax. In fact, 2012 has been labeled the year of the gift tax, partly because you can gift up to $5,120,000 tax-free this year, and the estate tax exemption is also the same amount. Those exemptions will decrease to $1 million each next year, and this year’s estate tax rate of 35 percent could potentially rise to 55 percent, more in line with historical levels. So if you are in the position to do so, take advantage of the current rules.

This also is the time to analyze whether to transfer from a 401(k) to a Roth IRA. If your wealth has substantially declined and your income is lower, you can transfer assets into a Roth at your lower income tax rate, and there is less tax to pay overall because the asset has lost value. After the transfer, the assets appreciate tax-free and the potential overall tax is less over time.

Business Owner Succession and TransfersLet’s say you are 70 and own a profitable metal fabrication distribution business that has $20 million in sales, with EBITDA (earnings before interest, taxes, depreciation and amortization) of $4 million. That’s pretty good in this sluggish economy, as most business sell at about six to eight times EBITDA, so the business might be worth $24 to $32 million.

Yet despite wanting to sell the business and begin transferring wealth to your two children, you are hesitating, because only five years ago, your EBITDA was $6 million and you were getting offers better than eight times EBITDA. If you wait a little longer, you might sell for more money. On the other hand, some owners die while waiting for things to turn around, opening up the estate to potentially higher estate taxes.

An alternative is to use this 2012 window as an opportunity. You can transfer assets such as ownership in the business to others at a lower historical value, thus paying less tax while taking advantage of 2012 rules. You can use entities to enable the transfer at better tax rates, such as partnership transfers that discount the value of the business inside the partnership.

The trick is to keep key employees, and that may include children, working in the business. One way is to provide incentives, such as a written contract stating that as the company increases in value, the employee will receive a cash bonus of, say, 20 percent of that increase. This doesn’t involve share transfers, only cash; therefore your beneficiaries are protected from erosion of their future share values.

Buy/Sell Insurance Policies on Business PartnersThere is insurance you can buy to protect closely held companies from losing a key owner or executive, and the recession impacts these policies. The buy/sell policy provides money to buy out an owner should he or she die or become disabled. It is priced at a level determined by a business valuation.

Businesses change in value, however, especially during a recession. For example, say the company is paying buy/sell insurance on a 60-year-old co-owner for a $20,000 annual premium. If the business is worth less, then the payoff amount that the policy covers needs to be reduced in order to save cash. As the business recovers in value, insurance has to be adjusted again and also going forward, depending on the health of the partners.

BeneficiariesIf you are a likely beneficiary of someone who owns a business, you should never rely on an inheritance. So much can happen or go wrong. The business value will rise and fall with economic tides.

What you want to do is work together to determine what ownership should be transferred, using the methods described above, including trusts and partnerships. These entities allow a business owner to maintain control of the asset while transferring some ownership.

Starting a BusinessRecessions take so much away, but they also give, many times in the form of a laid-off employee starting his or her own business. Supposing you follow your passion and decide you want to use your 401(k) or pension money to fund it? This needs to be analyzed closely, because if you’re paying more in tax penalties, it won’t be worth raiding your retirement fund.

If you are just coming off a good year of income, you’ll pay tax on redeeming your retirement at a higher rate than if you wait a year or two and base it on income that may potentially be lower due to the change in career or situation. Consider finding another way to fund the business, including friends and family loans or investments, or government program loans such as the SBA. Regardless of where you currently are on the wealth scale or how deeply the recession affected you, the important thing to understand is that you have options when it comes to estate planning and the transfer of assets. Take your time to evaluate all your options, but don’t let the tax rates of 2012 slip away before you’ve had a chance to do so.

Mira Finé, CPA, is the national director of tax operations for Hein & Associates LLP, a full-service public accounting and advisory firm with offices in Denver, Houston, Dallas and Orange County. She specializes in succession planning and can be reached at mfine@heincpa.com or (303) 298-9600.